In re Caremark International Inc. Derivative Litigation
698 A.2d 959 (Del.Ch. 1996)
Employees of Caremark were
indicted for violations of regulations applicable to health care
Those violations eventually
cost the company $250M.
Some shareholders instituted a
derivative lawsuit against the directors for breach of fiduciary duty.
The shareholders argued that
the directors knew, or should have known, about what was going on in the
company and stopped it before the company became liable for $250M.
Essentially, the directors
should have been more active monitors of corporate performance.
The parties came to an
agreement to settle the suit, and asked the Court for approval pursuant to
Chancery Rule 23.1.
The settlement agreement
gave the shareholders express assurances that Caremark will adopt a more
centralized, active supervisory system in the future by creating
Compliance and Ethics Committees.
The Trial Court approved the
The Trial Court found that
as long as the directors were acting in good faith to advance corporate
interests, the courts shouldn't question their decisions.
That would be a subjective
standard. The directors are held what they personally believed was good
corporate governance, not what a reasonable person would believe.
The Court noted that if the
directors were incompetent, it was the shareholders' fault for electing
The Court found that part of
what would make a 'good faith effort' on the part of the directors would
be to assure that a corporate information and reporting system exists and
that it is (in the opinion of the directors) adequate to detect
activities that could put the corporation at risk of liability.
The Court narrowly
construed Graham v. Allis-Chalmers Manufacturing Co. (188 A.2d 125 (Del. 1963)) which held that
the directors did not have responsibility to institute a monitoring
system to mean that directors' can decide for themselves what sort of
system they believe will be adequate to detect wrongdoing.
The Court noted that they
shouldn't second guess a director who says that they believed that the
system they had in place was adequate.
The Court found that, based
on the standard they had set, the shareholders would have been unlikely
to win in court. However, since the settlement was pretty modest and
generally changed the corporation for the better, it should be approved.
The Court found that there are
two conditions necessary for liability under the standard set by this case
(now known as the Caremark Factors):
The directors utterly failed
to implement any reporting or information system or controls; or
Having implemented such a
system or controls, consciously failed to monitor or oversee its
operations thus disabling themselves from being informed of risks or
problems requiring their attention.
In either case, imposition
of liability requires a showing that the directors knew that they were
not discharging their fiduciary obligations.